Defining Product versus Services Businesses
The genesis of this post is a comment I made about product companies at a large networking event earlier this week in Houston:
“If you think you’re a product company and you haven’t developed a repeatable sales model, then you’re a services company.”
In other words, if every deal closed is in a different vertical market and/or solves a different problem, then the transition from a services company to a product company is incomplete. What is the effect on the value of your company?
How to grow a company’s value is a topic I spend a great deal of time thinking about, and the 20/20 Outlook process focuses on aligning a company with others in the industry to grow a private company’s valuation. While that’s a vital driver of any corporate strategy, let’s consider how the form of a company’s offerings (specifically, products versus services) impacts its market value.
One attraction of starting a product company is the relatively rapid growth in valuation possible in comparison to that of a pure services company. To see why this is a critical issue, go to Yahoo Finance and compare the ratio of revenue to enterprise value for half a dozen public companies that derive most of their revenue from either products or services. For example, the well-run government services company Raytheon’s trailing twelve months’ revenue is $25 billion yet their enterprise value is only $18 billion, a ratio of 0.7. Compare that with your favorite products companies and you’ll find much higher ratios for well-run products companies.
Of course, customers demand varying amounts of service to accompany product purchases, thus few so-called product companies are successful without offering services as well. The percentage mix of product and services revenue can determine profitability and valuation, so it’s important to characterize the difference between products and services. Products and services both solve problems, but in their purest form, they do it differently. The chart below depicts these differences.
Cost - Any problem can be solved with enough services, but the cost may not attract any customers. Creating a product to solve the problem is an alternative, and the gap for customers who want more customization than the product offers can be filled with services.
Fit - Services by their nature enable delivery of customized solutions. Products exist because enough problems of a certain class can be solved well enough to satisfy most needs with a generalized solution.
EBITDA - Earnings vary widely, yet as a general rule, the EBITDA of a well-run product company can easily double that of a well-run services company of similar size.
In the software industry, for example, it’s fairly common for a services company to evolve into a product company over time. Consider the continuum below that depicts such an evolution, starting on the left with totally service-based solutions (“Custom Services”) and incorporating product-like characteristics as we move to the right and end with Product/Service solutions.
To the right of Custom Services is “Packaged Services.” Once you’ve solved the same problem several times, you can package a partial solution (60%? 80%?) that can be customized for each customer. Basing the price of the solution on value rather than level of effort (hours), profitability increases.
Continuing to the right, next to Packaged Services is “Product-Related Services.” If your staff becomes expert at designing, implementing, integrating, and managing solutions using highly desirable but complex products, the result is a scarce resource that can be sold at a premium and that raises your margins. The classic historical example is a services company that became a leading expert at implementing SAP systems.
If yours is a well-run product business or is evolving into one, the benefits include higher EBITDA and a higher valuation than those of a similarly-sized services business (“product only”). And finally, the highest valued companies are often those that have desirable products with an abundance of product-related services available, whether supplied internally or by partners.
As the line between products and services blurs with the introduction of new types of products delivered in new ways, it’s important to understand how value is derived. Does the statement about claiming to be a product company without developing a repeatable sales process ring true?
I ask forgiveness for some sweeping generalizations. Certainly, exceptions to this high-level look at valuation abound. Feel free to point them out and elaborate or disagree.
Every Portfolio Has (at least) One
Every private equity and venture capitalist investor I talk to has at least one portfolio company that stalls out. The company survives the original investment rounds to become an “established” business. Soon thereafter, the management team opts to focus on a single aspect of the business, e.g., “we’re going to focus on growing the customer base.” The monthly mantra becomes “keep the pedal down on sales, manage operational issues, and carefully manage cash.”
These activities are crucial to survival, yet the danger is that the CEO and management team can get comfortable working in the business and forget to work on the business. Neglecting to put a rational plan and adequate resources in place to enhance company value (including growing revenue) often leads to an abrupt plateauing of valuation that takes months and even years to recover from.
Initiating and maintaining productive relationships with relevant organizations at the right time establishes a decision-making context that maximizes the valuation of technology businesses. Created specifically to increase shareholder value, the 20/20 Outlook process enables a CEO to:
- view company value through the lens of potential acquirers,
- adjust market strategy and offerings accordingly, and
- initiate and maintain strong ties with key companies that can drive valuations ever higher.
The key is to intervene well in advance of a slowdown and put an enlightened process in place. Not doing so risks the ultimate loss of mega dollars and significant market share.
Important Indicators are Up
Because I help companies define an exit strategy and grow value accordingly, I’m always seeking better sources of data that capture the current state of the investment world. Pitchbook is one source that publishes particularly useful information about fundraising, investments, and exits. A recent Pitchbook presentation suggests that we’re on the verge of significant growth in private equity investment during the next year, and that’s good news companies moving toward an exit.
One factor mentioned in the Pitchbook prez is that capital overhang is high and growing. When that happens, valuations tend to increase because so much money is looking for a place to land and produce a return.
Additionally, chart below depicts that the number of quarterly private equity exits through corporate acquisitions, initial public offerings, and secondary sales is on the upswing after reaching a low in early 2009.
Finally, one of the best analysts in the business, Richard Davis of Needham and Company, commented in his newsletter that it’s been 25 years since he’s seen so many companies in a great position for an IPO.
Taken together, all these indicators suggest that, despite the continuing malaise in the broader economy, a CEO who keeps his/her company’s partnerships, product strategy, services, and partnerships aligned with potential acquirers can expect to see greater opportunity this year and through the next.
Optimal Board Conversations
Based on feedback from experienced CEOs, getting the optimal value from boards of directors is a common challenge. Of course, it starts with picking solid board members. As serial CEO Bill Bock said recently, “Building a strong board is every bit as important as building a strong management team.” He recommends at a minimum that you include at least one very strong financial mind and at least one “crusty operational type” on your board to provide balanced guidance to the management team. “The ideal director sees a bigger world than the CEO.”
Assuming that you already have the right people, deriving value from them is up to you, the CEO. You have to engage their best thinking while keeping in mind that they don’t manage daily operations – you do. Giving too much or too little control to the board can decrease its value.
By focusing on growing the value of the company, the 20/20 Outlook process provides a constructive framework for discussions at the appropriate level. Another serial CEO, Mike Shultz, describes 20/20 Outlook as “a methodology that is clear and focused on developing the strategies to fulfill Job One for the CEO and in the process, creates a framework for solid communications with the Board of Directors about their most important measurement of success.” Job One, of course, is increasing shareholder value.
The diagram below depicts the continuum of choices a CEO has for achieving value from his/her board of directors:
Two common problematic relationships with boards can develop: micromanagers and cheerleaders . A CEO may allow the board to have too much control and encourage micromanagement. Since board members often have CEO and operational experience, they can be easily tempted to fill any perceived vacuum in leadership that you display as CEO. While reviewing financial and operational performance is valuable and appropriate, constrain the resulting conversation to high level suggestions for improvement rather than drilling into the nuts and bolts of daily operations. (If a particular board member has directly applicable experience, engage that person offline and don’t occupy the entire board’s time.)
On the other hand, a CEO who over-controls the board wastes everyone’s time. Having a board full of cheerleaders that rubber-stamps decisions and flatters the CEO may feel good, but it defeats the purpose of having directors and prevents their having an impact on the value of the business.
Either extreme implies weakness. The CEO who allows the board to micromanage may lack confidence in his/her ability to lead, while the CEO who totally controls the board may incapable of handling constructive criticism. Optimally you want to engage the board in strategic conversations about increasing shareholder value.
Are you having optimal conversations with your board?
Assessing the Value of High Tech Companies
In a recent post, long-time friend and colleague Michael D’Eath speculated about how the acquisition landscape is changing, especially the extent to which roll-ups seem to be an increasingly frequent exit path for startups. Implicit in this process, of course, is how the startup will be evaluated.
A key component of the 20/20 Outlook process is assessing value in the eyes of potential acquirers. A value analysis framework I’ve found helpful consists of a total of 12 different attributes rated as “strong,”“credible,” “limited,” or “none.” In the diagram below, the 12 areas are built in 4 categories from the bottom up, starting with how flexible, patentable, and scalable the company’s technology is (“Credible Technology”).
Secondly, market credibility is assessed for how established the company is, the strength of the initial customer base, and how capable the company is in successfully delivering a solution (“Credible Market”).
Next, the health of the business is rated in three areas: vertical packaging, repeatable sales model, and repeatable delivery (“Credible Business”).
And finally, we make an analysis of progress in gaining a good reputation with the analyst community, achieving broad scale customer adoption, and market thought leadership is made (“Market Dominance”).
Assessing the current state of each attribute can highlight areas of weakness that need attention and perhaps more resources, as shown in this example.
With respect to Credible Technology, this theoretical company has flexible and patentable technology that is still somewhat limited in its scalability. It’s in an emerging market (i.e. established market = limited) that hasn’t quite broken through to mainstream (i.e. still low on the Gartner hype cycle). I won’t drag you through each attribute, but you can clearly differentiate those that are driving up value and that need attention.
